Goldman Sachs Charged with Civil Fraud

The investment bank that came through the recent unpleasantness better than others, Goldman Sachs, is in some trouble with the SEC. The Feds have brought a civil case against Goldman for alleged improprieties involving a collateralized debt obligation [CDO] known as Abacus 2007-AC1, a private placement and not a registered securities offering. Goldman Vice President Fabrice Tourre created and sold the vehicle, and the SEC alleges that he withheld "vital information" from buyers. This incident may just be the tip of the iceberg in SEC investigations, and it has made the financial reform bill an almost certainty.

Colin Barr writing for Fortune stated, "The SEC's civil fraud complaint alleges that Goldman allowed hedge fund Paulson & Co. -- run by John Paulson, who made billions of dollars betting on the subprime collapse -- to help select securities in the CDO. Goldman didn't tell investors that Paulson was shorting the CDO, or betting its value would fall. When the CDO's value plunged within months of its issuance, Paulson walked off with $1 billion, the SEC said."

There is nothing inherently illegal nor even immoral about Paulson shorting this CDO. The trouble is that if Paulson wanted to sell this short, there had to be a buyer. Since Paulson selected the securities in the CDO, it had an interest in selecting securities that were going to fall in value. Indeed, some sources say that within months 83% of the securities had been downgraded by rating agencies and the remainder were on downgrade watch. That suggests that Paulson was successful in packing the CDO with instruments that favored its position. Where this becomes illegal and immoral is in the failure of Goldman to tell buyers about Paulson's conflict of interest.

These counterparties are among the most sophisticated investment houses out there. It is difficult to believe that they would have bought Abacus if they knew of the conflict. Andrew Bary in Barron's wrote, "The losers from the Abacus deal were a German bank, IKB (IKB.Germany), which lost $150 million, and Royal Bank of Scotland (RBS), which lost $840 million." Goldman itself was at pains to point out that it lost $90 million on the deal; however, a loss isn't proof of innocence.

What is confusing here is why the charges are only civil. If Mr. Tourre deliberately withheld important facts from the buyers of Abacus, surely this is criminal fraud. It is unusual for civil charge to precede a criminal prosecution. Perhaps wiser legal minds can explain this situation.

A further issue is whether this is a one off case or whether, as one suspects, Mr. Tourre is not the only financial wizard whose behavior is going to come to the attention of the SEC. Goldman's defense in part is that they handled this in the customary way. If the custom is crooked, then Goldman is probably not going to be the only firm taken to task.

Politically, however, the complaint creates trouble for the Republican Party. They are the party of deregulation and of the bank bailout (it occurred in the autumn of 2008, when Mr. Bush was in the White House). A great many tea party supporters are angry about the bailout and the bonuses. Yet, the party's congressional leadership appears to be supporting Wall Street. One expects that the pressure to reform financial regulations from Main Street will now become irresistible. This could be another win for the president, courtesy of his opponents' ineptitude and inability to understand the electorate.

© Copyright 2010 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Ubuntu Linux.

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